Scenario analysis for a portfolio manager, Financial Management

A portfolio manager would never prefer to make investment decision based on just one set of assumptions. Instead, he would evaluate the outcome of the selected strategy under various scenarios to determine what happens to total return when different sets of assumptions are used. This process of evaluating a strategy under several scenarios is called as scenario analysis. The various assumptions made for computing total return are assumptions regarding interest rates at the end of the investment horizon, spreads at the end of the horizon, and reinvestment rates over the investment horizon.

Controlling For Interest Rate Risk

When we assess two or more strategies, it is important to compare positions that have the same rupee duration. Duration is the change in the value of bond that will result from a 100 basis point change in yield. Let us consider two bonds P and Q. The price of bond P is 70 and has duration of 6%, and bond Y has a price of Rs.80 and duration of 5%. When the yield of bond P changes by 100 basis points, the value of the bond would change by Rs.4.2. For bond Q the value of the bond would change by Rs.4 for a change of 100 basis points. Now let us suppose that a portfolio manager has Rs.10,00,000 of par value of bond P. The market value of the portfolio is Rs.7,00,000. The rupee duration of the bonds for a change in 100 basis points in yield is equal to Rs.42,000. The manager decides to exchange the bonds for bond Q, but wants to maintain the same interest exposure on the new bonds that he intends to acquire. If he exchanges Rs.10,00,000 par value of bond P for Rs.10,00,000 par value of bond Q, the market value of bond Q will be equal to Rs.8,00,000. Then the new rupees duration would be Rs.40,000. Therefore to maintain same rupee duration the manager should purchase bond Q with market value equal to Rs.8,40,000. Then the rupees duration for the new portfolio will be Rs.42,000 (8,40,000 x 5%). For this, the manager should purchase Rs.10,50,000 of par value of bond Q.

The market value of bond Q needed to maintain same rupee duration as bond
P = Market value of bond Q = Rupee duration of P/duration of bond Q/100

Par value of the bond Y = Market value of bond Q/(Price of the bond Q/100)

Taking the data from the above example, we can see the working of the above two formulas as follows:

Duration of bond Q = 5

Rupee duration of bond P = Rs.42,000

Market value of bond Q = Rs.42,000/(5/100) = Rs.8,40,000

Par value of the bond Q = 8,40,000/(80/100) = Rs.10,50,000.

 Conclusion

If a manager fails to adjust a trade based on some expected change in yield spread so as to hold the rupee duration the same, then the outcome of the trade will be affected by the change in the yield level and also by the expected change in the yield spread.

Posted Date: 9/11/2012 1:51:01 AM | Location : United States







Related Discussions:- Scenario analysis for a portfolio manager, Assignment Help, Ask Question on Scenario analysis for a portfolio manager, Get Answer, Expert's Help, Scenario analysis for a portfolio manager Discussions

Write discussion on Scenario analysis for a portfolio manager
Your posts are moderated
Related Questions
As we know, zero-coupon bonds are issued without any periodic coupon payments. The investor gets the interest and the principal on a maturity date. The interest i

How would you judge the potential profit of Bajaj Electronics on the first year of sales to Booth Plastics and give your views to increase the profit.

Capitalization ratios are used for determining the extent to which the corporation is trading on its equity, and the resulting financial leverage. These ratios

Why is the replacement value of assets method not usually used to value complete businesses? The replacement value of assets process is not often applied to complete business v

Provide three examples of mutually exclusive projects. Mutually elite projects are projects that compete against each other for our selection.  If a firm were considering the b

How do opportunity costs affect the capital budgeting decision-making process? Opportunity costs imitate the foregone benefits of the alternative not chosen while a capital budge

What is the matching principle of working capital financing?  What are the benefits of following this principle? The matching principle is while short-term financing is used fo

QUESTION (a) Describe briefly three methods of electronic payment. (b) (i) Explain briefly the term E-Billing. (ii) Outline three advantages of E-Billing. (c) Why is c

How does a preemptive right protect the interests of existing stockholders? A preemptive right defends the interests of existing stockholders by providing them the opportunity to

Under what circumstances will the foreign subsidiary’s financial structure become relevant? The subsidiary’s own financial structure will become applicable when the parent firm